Should Student Loans Be Repaid by Refinancing Homes?

NEW YORK (MainStreet)What happens when students - or their co-signer parents - are having difficulty repaying a student loan? Is getting a second mortgage, obtaining a home equity loan or a HELOC (Home Equity Line of Credit) an advisable option to repay the debt?

Yes and no, say the experts. This unfortunate ambivalence among those in the know does not help those who are unskilled in the arcane ways of finance.

Those who warn against using a house say it is foolish to trade an unsecured debt for a secured one. Those in favor say there may be some advantages to refinancing a house to repay student loan debt but it involves great risk  especially for parents.

"You may get a better rate or longer term for a refinance," said Wharton finance professor David Musto about the wisdom of repaying student loans with a loan against a house. "Let us say you take cash out of a property--you could get a better rate. But now you expose yourself to foreclosure. It is hard to judge. If you are a parent paying the loan there are one set of considerations. But if it is just, say for example, myself, and I am getting an MBA, but I increase my mortgage payments--this creates some stress."

Musto noted an important factor in determing what to do is future income. But this is complicated to determine. Although in some professions there is a specific correlation between getting a degree and higher income this is not always the case. For example, school teachers have a clear path between obtaining a degree and increasing income. But in other fields the relationship is not guaranteed. So one is betting one's house on the investment of a higher education when one takes out a loan against their residence.

To boot, Musto also noted that student loans since the 2005 bankruptcy reform act, both federal and private, are not dischargeable in bankruptcy. This makes it almost impossible to walk away from the debt  but one is still not losing a home.

There is also a provision for student loans to defer payment while still in school, but interest accrues even though deferred. There are also some forgiveness provisions available for federal student loans. None of these options exist with a home mortgage.

"Any time you change an unsecured debt to a secured debt you will get a lower rate," Musto explained. "But the cost is that you are securing it with an asset that may be seized. On the other hand student loans, even though they are unsecured, are loans in which the creditor has a strong claim in bankruptcy because the debt is not dischargeable."

Opposition comes from Gary Carpenter CPA, the founder and executive director of the National College Advocacy Group (NCAG) in Syracuse, NY.

He advises against taking a loan against one's house. He believes it is contrary to normal borrowing practices.

"You are taking an unsecured debt and turning it into a secured debt using an asset," Carpenter explained. "When borrowing money, one should always look for unsecured debt before anything else. It is the most beneficial loan arrangement. If unsecured debt is not available then the second option is to secure the debt with an asset."

Carpenter pointed out that if one refinances a house, one is sacrificing an asset. If the loan is in default then one could lose the property.

He also said that student loans are not dischargeable in bankruptcy. This makes them attractive to lenders. Lenders can also garnish wages and put liens against a property to collect the debt. Carpenter added that if it is a federally guaranteed loan a default can be collected by garnishing Social Security payments and income tax refunds.

But these are all more expensive options for a lender to use to collect a defaulted loan than simply foreclosing on a property and putting it up for sale.

The Consumer Protection Financial Bureau (CFPB) issued a statement June 7 about the advisability of paying off a student loan with a loan obtained by borrowing against a house. Their assessment was equivocal. It came in the form of a blog by Rohit Chopra, the CFPB's Student Loan Ombudsman. He discusses using home equity loans to refinance student loans.

"This can be risky," Chopra cautions. "Student loan borrowers who have built equity in their homes may find that paying back outstanding student debt with a new home equity loan looks appealing, given today's historically low interest rates, but putting more debt on your home can lead to problems down the road."

Chopra recommends that before one takes out a home equity loan to repay a student loan, an attempt should be made to find a student loan refinance product first. Once located, compare the rates. It is possible to lower the interest rate "without some of the risks that come with a decision to tap the equity in your home."

He said that there are a few things to keep in mind:

1. "Your rate may be lower, but your home is at risk," Chopra said. "Interest rates for home equity loans are generally lower than interest rates for student loans. (Lenders are willing to offer a lower interest rate because they know that if you don't pay, they have a legal claim on your home.) If you can't pay, you could end up in foreclosure."

2. "On your federal loans, you are giving up repayment options and forgiveness benefits," Chopra said. "Federal student loans feature a number of protections for borrowers that run into trouble, including Income-Based Repayment (IBR). These benefits no longer exist when you pay off a federal student loan with a home equity loan."

3. "This may impact your taxes," Chopra warned. "The interest you pay on a home equity loan could equate to a greater tax benefit for some borrowers, when compared to the student loan interest tax deduction, especially if you have high income and itemize deductions. You may wish to consult with a tax advisor when considering your options."

Chopra concluded that for those who have substantial savings, steady income from stable employment and someone who is knowledgeable about finances, using a house may offer an opportunity to repay student loan indebtedness at a lower interest rate.

"But again, there is always a risk of losing your home if you don't make your payments," he warns.

One factor about converting a student loan debt to an asset secured debt is the tax deductibility of the loan.

Student loan interest is deductible as an adjustment to income. Therefore, it is not necessary to itemize to reduce taxable income. But there are income limitations for being able to claim the deduction. Single filers with a modified adjusted gross income (MAGI) less than $60,000 and married couples filing jointly with incomes less than $125,000 receive the full deduction. The deduction phases out between MAGIs of $60,000 and $75,000 for single filers and between $125,000 and $155,000 for married couples filing jointly.

But with a second mortgage or home equity loan the interest is deductible as an itemized deduction. The limits on the deduction on mortgage and home equity interest vary. The interest deduction is limited to the interest on $1,000,000 for a mortgage used for an acquisition of property - for a married couple filing jointly. This is reduced to $500,000 for a married couple filing separately. For home equity loans one cannot deduct interest on principal of more than $100,000.

The question of taking a second mortgage or home equity loan to pay college tuition is a complicated one. A cost-benefit analysis factoring in future income, the job market, the monthly payments, term of the loan, forgiveness provisions and the net payment after tax are just some of the considerations.

Anecdotal evidence indicates that many people take out a second mortgage on their homes to pay for their kids' tuition. They usually do it as a last resort making it an even riskier proposition.

The CFBP does not have any data how often student loans are repaid by second mortgages or home equity loans  or for that matter how many people use their homes to pay for their kids' college education. Indeed, data in general regarding the collateralization of one's property for a college education is something of a black box to the powers that be. Certainly no one knows how many people have lost their homes because of this.

Nonetheless, one thing is certain  many Americans are literally mortgaging their futures for their kids.